Banking, Financial Markets and Systems

‘Contributors to the depreciation of the Indian Rupee and Its Impact on Indian economy’

Executive Summary

The fall of rupee has been a regular event since last three months and recently the rupee hit an

exchange rate of 61.80 against the USD which is its lowest value ever.The fall started last

year with fluctuation between INR 45 to 55 per dollar and in the first quarter of FY2014, the

rupee has fallen by more than 12%.

Through this paper, we have tried to analyze various causes that have led to this unfavourable

situation and the impact of a depreciating rupee and future course of actions that could revive

the foreign reserves. Effort has been made to give reasons and analyze the complete event in

depth.

Contents

Executive Summary...............................................................................................................................................2

Alarm bells for the Rupee......................................................................................................................................4

Causes of Rupee’s Depreciation.............................................................................................................................5

Tapering of Quantitative Easing by US Fed.......................................................................................................5

Global Economy and Recession.........................................................................................................................6

Strengthening of the USD in regards to other Currency....................................................................................6

High Volatility of Indian Currency......................................................................................................................7

Current Account Deficit and Trade Deficit.........................................................................................................7

Government Policies..........................................................................................................................................8

Fiscal Deficit......................................................................................................................................................9

Persistent Inflation..........................................................................................................................................10

Impact of depreciation on the Indian Economy...................................................................................................11

Rise in Inflation................................................................................................................................................11

Investment Climate.........................................................................................................................................11

Possibility of Interest rate rise.........................................................................................................................12

Foreign education and foreign travel..............................................................................................................13

Current Account Deficit (CAD).........................................................................................................................13

Who benefits from rupee’s depreciation?.......................................................................................................13

Closing Comments...............................................................................................................................................13

Bibliography........................................................................................................................................................15

Exhibits................................................................................................................................................................16

Exhibit 1: Comparison of Indian currency (INR) against American Dollar (USD), British pound(GBP), Europian EURO, Japenese YEN and Chinese YUAN.........................................................................................................16

Exhibit 2: INR future rate against various currencies.......................................................................................19

Exhibit 3: June, 2013 Exports and Imports data..............................................................................................19

Alarm bells for the Rupee

The value of rupee is expected to move with the same pace with the value depreciating in the

times to come. All the efforts made by US government to strengthen their economy will

further lead to the depreciation of Indian currency. However the current currency problem is

not limited to India as majority of emerging market is also facing similar problems. So, many

experts believe that its’ not depreciation of rupee that we are currently observing, it is more

about appreciation of dollar. But the trends shown in Exhibit 1 clearly indicates that the

rupee is depreciating against all the major currency and the trend of depreciation against these

major currencies is almost similar. Exhibit 2 indicates the trading of various currencies in

OTC market, which clearly captures the perception of people about further fall of rupee.

(Staff, 2013)

The depreciation is governed primarily by the rule of demand and supply of money across

different nations and with India’s currrent account deficit of the range of 4.8% of GDP, the

situation is not good and if major actions are not taken to revamp exports and attract Foreign

investors, the situation is not going to turn for Indian rupees. The demand of oil and gold is

the prime reason for structural weakness of current account deficit.

The impact of this depreciation is many fold and leads to a vicious circle, wherein the effects

of the depreciation acts as a cause to further weakening of the currency. For instance, the

import of crude oil is a neccesity and the more rupee depreciates, the more India has to invest

for the crude oil which will further deplete the foreign reserve leading to more weakening of

the Indian currency. Despite the fact that RBI has been trying hard to increase the liquidity,

things have not improved much. With just $ 280 billion reserves which could only support

import for next seven months, India is in deep crisis of dollar supply. With Fed’s plan to

inject dollar in US economy at the rate of $ 85 billion a month through bonds purchase, the

ruppee is going to be hit further more in coming months. (Reuters, 2013)

Causes of Rupee’s Depreciation

The rupee depreciation can be attributed to both external and internal reasons that are

happening now. The external reasons are because of the policy changes by the US

government and also the state of the global economy.

Tapering of Quantitative Easing by US Fed

Quantitative easing was undertaken by the US federal Bank in order to stabilize the US

economy and kick start the growth of the US economy. In order to do that, the US federal

bank lowered the interest rates in the US system and reduced the interest rate to historical low

of .25%. After this as they could not reduce the interest rates further, in order to inject further

liquidity in the system, the US started buying bonds from the open market and injecting

around USD 85 billion each month and increased the liquidity in the US system.

Because of this reason, yields on the US bonds were very less and the institutional investors

tried to invest the funds with them in places where they could get more yields than they

would be getting while being invested in US. They invested huge amounts in the emerging

markets like India, Brazil and other Asian countries.

It is expected that the quantitative easing by the US federal bank would be stopped once the

unemployment reaches below 6.5% with the inflation rates anchored at 2%. It’s expected that

this situation could be attained in April 2014, and there is a signal of tapering of bond

purchases by the US federal government by the end of this year. With the revival of the US

economy shown by the unemployment rates and housing price stats, it is expected that the

quantitative easing would be tapered and finally withdrawn in the near future.

If the quantitative easing is withdrawn, the yields in the US treasury bonds would rise. If the

yields in the Treasury bond rise, then the spread between the G-secs and treasury bonds

would be very less and India will lose its attractiveness as an investment destination for FII’s.

India’s stock market and debt market has received huge amount of investments from the FII’s

in 2012. FII’s have started pulling out their investment in the country and they have

withdrawn a staggering 10.5 billion USD in the months of June and July alone leading to

selling of rupees and buying of Dollars which has contributed to the depreciation of the

Indian Rupee to a major extent.

Global Economy and Recession

The USA (11.9% of exports) and Europe (19% of exports) have always been major markets

of Indian exports. Anything which affects this growth of economy, will affect the Indian

economy as well as the Indian currency. With the slowdown in this economy, the demand for

Indian exports has come down leading to the widening of the CAD (Current Account Deficit)

of India. A widened CAD always is accompanied by the depreciation in the Indian Rupee.

Strengthening of the USD in regards to other Currency

The probable exit of Greece from euro zone is looming large and adding to that the other

countries like Ireland, Portugal, Spain and Italy are in recession and they have huge debts in

the European central banks, and so the exit of Greece may cause the Euro central bank to

stomach huge losses. In order to save the banks, huge amount of Euro is needed and the two

biggest economies Germany and France are also in trouble, these two countries bear most of

the bonds of the Euro banks and the collapse of these banks would greatly affect the

economies of Germany, France and Italy. This crisis has led to the instability in the Euro’s

and the USD dollar is becoming the most stable currency. All the investors would try to make

the investments in USD increasing the demand for USD which has further lead to the

appreciation of USD in terms of Indian Rupee.

High Volatility of Indian Currency

The high volatility of the Indian currency has led to the increase in costs of hedging the

Indian rupee. This increase in the cost of hedging has further lowered the returns got by the

FII’s in India. Since the returns are lowered, the FII’s have started to pull out their investment

in India and as explained earlier they have pulled around 10.5 billion USD in the past two

months itself leading to the excess supply of Indian rupee’s and also demand of the USD has

increased leading to the depreciation of the Indian rupee.

Current Account Deficit and Trade Deficit

The depreciation of Indian rupee has had a huge impact on the Imports of India. India is more

of an importer rather than an exporter. India Imports 80% of the total oil needs and with the

increase in global crude oil prices, there is a huge impact on the imports. If we talk in

absolute terms, every 10 dollar increase in the price of an oil barrel increases the Indian

current account deficit by roughly $6.5 billion dollars. The current account deficit has

widened to a range of 4.8 percent of the GDP, even though in the fourth quarter it moderated

to 3.6% of GDP, still the current account deficit is high while the trade deficit is even larger

at around 7 per cent of GDP.

Further, recent trends indicate a significant worsening of both trade and current accounts.

Both exports and imports actually declined in 2012-13 compared with the previous year, but

even so the trade deficit still increased by nearly 4 per cent, or more than $7 billion. In April

2013, exports were 2 per cent higher than in April 2012—but imports were 11 per cent higher

and non-oil imports were 15 per cent more. So the trade deficit increased by more than 26 per

cent in April 2013 compared with the previous year (Finance Ministry, Monthly Economic

Report for April 2013).

Crude oil represents 30.1% of the total Indian imports in dollar value. However, an

interesting point to note is that Gold & Silver represent 10.1% of the import basket. This

fetish for Gold & Silver is unique to India and has created a serious problem for the RBI

governor on the current account deficit front. Economists talk about the J curve coming into

play when imports will eventually become expensive and thus their demand of the goods will

come down. But in case of India, the oil goods are highly subsidized. This has led to the

inelastic demand of the oil products in India, and thus even with the increase in crude oil

prices in the world market, the Indian demand for the oil has not come down thus increasing

our CAD, In the case of Gold and silver imports, the recent decrease in the Gold prices in the

world market has increased the demand for gold in Indian market further widening the

current account deficit in our country. This has become a vicious circle with higher CAD

leading to depreciation of rupee and a weaker rupee further widening our CAD. The weaker

rupee can be assumed to be beneficial to the exporters as they would be more price

competitive in the global market. But due to imports, the cost of raw materials for most of the

exporters have gone up thus stripping them of their advantage got with the depreciation of

rupee. Thus the advantage is lost and they are not able to sell their goods at lower prices. In

the current scenario of high recession, it’s very difficult for the exporters to increase their

exports, thus the depreciation of the Indian rupee has not helped us much.

Government Policies

Policy paralysis and non-implementation of the proposed policies is been cited as one of the

major reasons for the depreciation of rupee. Even though the bill regarding the multi brand

retail has been passed, it has failed to create any meaningful investment in the multi brand

retail has occurred because of many of the clauses in the bill and the uncertainty involving the

implementation of the bill in different states of the country. The GAAR, which are aimed at

reducing tax avoidance by introducing rules and also the implementation of GAAR

retrospectively has created enough furor and has also dissuaded foreign investors from

investing in India which has dried up the investments into our country reducing the demand

for the rupee. Some of the policies like Direct tax code, Goods and service tax has been in the

pipeline for implementation for a long time but haven’t been implemented still which has

created negative sentiment about the business environment of India and thus dissuading the

foreign investors from investing in India. Implementation of GST is expected to boost the

business environment in India and will help increase the level of foreign investments which

in turn will support the rupee. Till now, the government has just managed to take a few small

steps like increasing the limit for foreign institutional investments in government securities

and increasing import duty on Gold to support the plummeting rupee. On the other hand, RBI

has taken steps such as tightening the norms for rupee forward contracts, raising interest rates

on non-resident deposits and announcing relaxations in external commercial borrowings to

support the rupee.

Fiscal Deficit

India’s fiscal deficit stands at 5.6% of the GDP or 2.63 trillion rupee’s and in order to finance

this expense, the government has to issue bonds from the public and this causes the decreases

in the money available in the market which can be used for the purpose of investment thus

slowing down the economy. This also increases the cost of borrowing for the corporates since

the government demand for money is inelastic to the rise in interest rates and so naturally the

interest rates would rise. With the increased cost of capital, the corporates would be reluctant

to borrow and invest in new projects leading to stalling of economy and stalling of

employment generation in the country. The increased fiscal deficit may also lead to

downgrading of the Indian business environment reducing the inflow of the money and also

increasing the cost of capital for the companies. So in order to overcome this, the government

has to reduce the subsidies or increase the taxes and both will affect the economy. Increasing

the tax will reduce the disposable income in the hands of the common man thus slowing

down the economy. the increased fiscal deficit has put a huge pressure on the government to

reduce its spending on items such as petrol and fertilizer subsidies. But due to the populist

measures taken by the government and the pressures of coalition politics, it has been unable

to reduce this spending. In fact, the government has increased the outlay for public

expenditure in some areas. The implementation of the food security bill will also increase our

fiscal deficit. With the elections nearing, the government would not be willing to reduce the

subsidies in near future.

Persistent Inflation

In the past 2 years, India has experienced huge inflation and has remained above 8%. The

prolonged inflation will lead to overall worsening of the economy and causes the currency

outflows to happen thus depreciating the currency. REER index measure includes the level of

inflation differences across nations; it reflects a country's competitiveness in international

trade. The Real Effective Exchange Rate (REER) index has come down by 13.84% during

the last year while the nominal rate has depreciated by 24%. The trend shows that the

country's competitiveness has not improved as much as the decline in nominal exchange rate.

This mainly points out to the fact that there is an increase in domestic costs. Generally the

increased inflation can be overcome by raising the interest rates but in India, since the interest

rates were already high, it couldn’t be raised further thus leading to higher inflation in the

country. Because of this, the countries companies have become less competitive and even the

gains made by the depreciation of rupee for the exporters doesn’t impact much by way of

increasing the exports.

Impact of depreciation on the Indian Economy

The weakening of the Indian Rupee has had a variety of influences on the Indian Economy.

The most critical among them are:

Rise in Inflation

India is a net importer of goods and services. According to a recent press release by the

Economic division of the Department of Commerce (Ministry of Commerce and Industry,

2013), India’s net imports were $ 11244.45 million in June, 2013 alone. Refer Exhibit 3 for

exports and imports data in the month of June. As the currency depreciates more INR would

be needed to purchase 1 USD and this will increase the input prices of raw materials in

various sectors of the economy and the high weightage of close to 35% that global

commodities have been given in the wholesale inflation basket will place an upward pressure

on the Wholesale price index (WPI). In sectors such as petroleum and natural gas, electronic

gadgets, fertilizers and organic chemicals where India is heavily dependent on imports,

increased costs for the companies will be passed on to the customers in the form of an

increase in the prices of products. The prices of petrol and diesel have already been increased

as crude oil is the largest item in the list of India’s imports and due to depreciation, the cost of

importing oil has increased. Very recently, Panasonic India declared that they had factored a

level of 62 for USD/INR and would increase prices of their products if the rupee depreciated

further. (Das, 2013)

Investment Climate

With the fall of the Indian rupee, the return that foreign investors get from their investments

in India will reduce. Due to this, Foreign Institutional investors (FII’s) will take out their

money from India and invest it elsewhere due to concerns of a falling rupee. In the month of

June alone, FII’s pulled out more than $7 billion from the equity and debt markets in India

which led to increase in yield of government securities. This is because their returns in dollar

terms would reduce as they would need more rupees to get the same amount of dollars as the

rupee continues to fall. Reduction in capital inflows has occurred due to the rupees

depreciation and the RBI’s tightening of the monetary policy has encouraged companies to

delay investment and expansion plans. For companies that have taken debt in foreign

currency, i.e. External Commercial borrowings (ECB’s), depreciation of the rupee would

have an adverse impact on their Income statements. To repay this debt in foreign currency,

the company would now need more rupees than before to repay debt if we consider that

repayment is in monthly instalments. Recently, Adani Enterprises posted a huge loss in the

first quarter of 2013 due to the rupee’s volatility. The fact that they had to import coal due to

shortage of coal supply in India also led to increased cost of raw material. (Press Trusst of

India, 2013).

Possibility of Interest rate rise

In order to control the fall of the rupee, the RBI has tried to tighten the monetary policy and

reduce liquidity in the Indian financial system. By doing this, the RBI hoped that demand for

INR would go up vis-à-vis the USD and rupee would appreciate. But the sale of government

bonds, increase in Cash Reserve Ratio (CRR) did not achieve the purpose. The next possible

move is to increase the Repo Rate. If this happens, bank would have to pay a higher interest

on their borrowings from RBI and this higher interest will also be passed on to customers in

the form of increased interest rates. This situation is in stark contrast to the beginning of the

first quarter of FY2014 when interest rates were expected to fall and this change can be

attributed to the depreciation of the Indian rupee. Interest rate hike would enable inflow of

capital from foreign countries and strengthen the rupee. But it would also mean that

borrowers would have to pay higher interest on their loans and this would deter new

investments in projects.

Foreign education and foreign travel

Depreciation has also had an impact on those who want to pursue foreign education or travel

abroad. They would now need more rupees to purchase foreign currency to meet their needs

abroad.

Current Account Deficit (CAD)

Depreciation of the Indian rupee will favour exporters in India. However, considering the

imbalance of imports and exports in India, this advantage is nullified. Hence the Current

Account Deficit (CAD) will continue to widen.

Who benefits from rupee’s depreciation?

The major benefactor of the rupee’s depreciation has been the IT industry. Because the

industry majorly earns revenues in dollars, the rupee value of the earnings has substantially

increased and IT companies have posted handsome profits in the 1st quarter of FY2014.

Another industry that benefits is the tourism industry. Depreciation of the rupee means more

INR per unit of foreign currency and tourists can gain more value for their currency in India.

Also NRI’s who remit earnings to India stand to gain due to fall in the rupee’s value.

Closing Comments

RBI should take steps to curtail the free fall of rupee because of the impacts it has on the

Indian economy. The RBI should concentrate on the monetary policies and the government

should lay down policies such that the investment climate is improved in the country. The

major reason of policy paralysis should be overcome with slew of measures helping in kick

starting the economy and also bringing in investments. Some of the measures like increasing

the FDI limit in different sectors should be increased. This would increase the investment in

the country and help in overcoming the huge Current account deficit that India has now.

As a short term measure, RBI is trying to increase the interest rates which will also bring the

investments into the country so that the spread between the investment in the USD and the

Indian rupee remains the same. This will ensure that the foreign investors will keep invested

in the country. The other thing it can do is to sell the FOREX reserves it has with it so that the

demand for rupee could increase. RBI can take steps to increase the supply of foreign

currency by expanding market participation to support Rupee. RBI should increase the FII

limit for investment in corporate debt bonds and government debt bonds. It can invite long

term FDI debt funds in infrastructure sector. The present ceiling on the ECB can also be

increased.

Another important measure taken by RBI is to temper the speculation led volatility by

curbing the trade in rupee forwards and this will also lead to stabilizing the Indian rupee.

These are short term measures.

As a group, the depreciation of rupee is not good for the economy to grow and we feel that in

long term, the rupee will stabilize against other currencies only if the investment climate is

improved in the country and also the fiscal deficit and current account deficit is reduced,

which will help a long way in helping in Indian economy to grow as strong currency is one of

the major needs for growth.

Bibliography

Das, S. (2013, August 9). If rupee breaches 62-mark, we will have to raise prices: Panasonic. Retrieved from Business Standard: http://www.business-standard.com/article/companies/if-rupee-breaches-62-mark-we-will-have-to-raise-prices-manish-sharma-113080900606_1.html

Ministry of Commerce and Industry. (2013, July 12). Press Release: India's Foreign trade, June 2013. Retrieved from Ministry of Commerce and Industry: http://commerce.nic.in/tradestats/filedisplay.aspx?id=1

Press Trusst of India. (2013, August 08). Adani Enterprises plunges into loss in Q1 due to fall in rupee. Retrieved from NDTV Profit: http://profit.ndtv.com/news/corporates/article-adani-enterprises-plunges-into-loss-in-q1-due-to-fall-in-rupee-325560

Reuters. (2013, August 13). Rupee unlikely to regain ground against dollar over the next year.

Staff, F. (2013, June 19). Rupee hits 58.7 against $, will it depreciate more and surpass its record low. India.

Exhibits

Exhibit 1: Comparison of Indian currency (INR) against American Dollar (USD), British pound(GBP), Europian EURO, Japenese YEN and Chinese YUAN

Graph 1: USD against INR for the period of last 5 years

Graph 2: American Dollar (USD) against INR for the period of last 180 days

Graph 3: EURO against INR for the period of last 180 days

Graph 4: British Pound (GBP) against INR for the period of last 180 days

Graph 5: Japenese YEN against INR for the period of last 180 days

Graph 6: Chinese YUAN (CNY) against INR for the period of last 180 days

Exhibit 2: INR future rate against various currencies

Currency Futures & OTC Arbitrage Rates

08 Aug 2013

CURRENCY PAIR

1st Month 2nd Month 3rd Month

OTC Rate C/F Differ OTC Rate C/F Differ OTC Rate C/F Differ

GBP/INR 95.38 95.24 -0.14 96.14 95.8 -0.34 96.86 96.36 -0.5

USD/INR 61.57 61.5 -0.07 62.07 61.88 -0.19 62.57 62.23 -0.34

EUR/INR 82.04 81.97 -0.07 82.64 82.45 -0.19 83.24 82.84 -0.4

JPY/INR 63.65 63.49 -0.16 64.11 63.84 -0.27 64.62 64.19 -0.43

Exhibit 3: June, 2013 Exports and Imports data

EXPORTS & IMPORTS : (US $ Million)(PROVISIONAL)

JUNE APRIL-JUNEEXPORTS(including re-exports)2012-13 24923.11 73491.772013-14 23785.64 72455.67%Growth2013-14/ 2012-2013

-4.56 -1.41

IMPORTS2012-13 36167.56 115708.502013-14 36034.74 122635.73%Growth2013-14/ 2012-2013

-0.37 5.99

TRADE BALANCE2012-13 -11244.45 -42216.732013-14 -12249.10 -50180.06

EXPORTS & IMPORTS : (Rs. Crore)

(PROVISIONAL) JUNE APRIL-JUNE

EXPORTS(including re-exports)2012-13 139644.68 397884.012013-14 138901.73 405104.78%Growth2013-14/ 2012-2013

-0.53 1.81

IMPORTS2012-13 202647.54 625872.802013-14 210433.14 684167.73%Growth2013-14/ 2012-2013

3.84 9.31

TRADE BALANCE2012-13 -63002.86 -227988.792013-14 -71531.41 -279062.95